ECON 1110 Lecture Notes 8
ECON 1110 Intermediate Macroeconomics
James R. Maloy
Spring 2011
Lecture Notes for Topic 8: Keynesian Macroeconomics (IV)
Readings: Froyen Chapter 8 (8
th
Ed. Ch. 9)
I.
The Keynesian View of Prices
We have seen that the intersection of IS and LM give the level of aggregate
demand, but until this point we have assumed that the price level was fixed, and that
whatever quantity was demanded could be provided at that given price level.
At the time
of Keynes'
General Theory
(1936) it was not an unacceptable argument—during the
Great Depression output was so low and resources so underutilised that any increase in
demand could probably be met without triggering inflation, which is often the result of
high demand putting pressure on scarce resources (demandpull inflation).
Keynes had several rationales to explain sticky prices.
One was the idea of
menu
costs
.
There are administrative costs associated with a change in prices, such as changing
signs and printing new menus.
These can discourage sellers from rapidly changing
prices.
Another explanation could be
customer relationships
.
For example, in 1995
France raised VAT (value added tax; i.e. sales tax) by 2%.
However, to attract customers
and maintain a good relationship with existing customers, many stores chose to absorb
the increase and still sell for the same VATinclusive price.
Furthermore,
contracts
can
bind a company into selling something for a certain price for a certain time frame, thus
making prices rigid.
However, anyone can see from everyday life that the assumption of completely
fixed prices in generally unreasonable in normal times.
An increase in demand under a
full employment situation will put more pressure on scarce resources (including workers),
and will therefore drive up price levels.
In order to get a better picture of an economy
with variable prices, we need to derive Keynesian aggregate demand and aggregate
supply curves, which will demonstrate the relationship between output and prices.
1
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ECON 1110 Lecture Notes 8
II.
The Keynesian Aggregate Demand Curve
We have spent considerable time in previous weeks discussing the factors that
determine aggregate demand in the Keynesian system.
These factors are, namely, the
ones that determine the IS and LM curves and the interest rate and income level at which
the money market and goods market are simultaneously in equilibrium.
Since the
intersection of IS and LM gives the level of AD (which we , in order to derive the
aggregate demand curve, it is necessary to see how a change in prices will affect the
real
variables in the ISLM model.
The IS curve is given by:
I
(
r
) +
G
=
S
(
Y
) +
T
Government spending and taxes are set by the government in real terms, and a change in
the price level will not affect their real values.
Investment is given in real terms—the real
level of investment depends on the interest rate, so for any given interest rate real
investment will be the same.
Likewise, real savings depends on real income, and the
level of real savings is therefore not directly dependent on the price level.
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 Spring '08
 TedLochTemzelides
 Macroeconomics, Inflation, Supply And Demand, price level, Keynes

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